The Federal Reserve failed to compel SVB Financial Group to contribute its $4 billion in assets to Silicon Valley Bank. It had power to do so under Regulation Y, which requires holding companies to serve as a "source of strength" for their banks. And the Dodd-Frank Act directs the Fed to take that action, But it did nothing in SVBFG's chapter 11 case, so the FDIC was out $4 billion.

The FDIC and the Fed responded last August, by announcing a proposed rule, with comments due Jan. 16, that would preemptively enforce the "source of strength" doctrine against large bank holding companies—even those with no strength of their own.

The proposed rule seeks to reduce FDIC losses in future bank failures, but the rule is unnecessarily expensive and inadequate to its task. There's a better way.

On its face, the proposed rule says nothing about "source of strength." Instead, the rule requires each large holding company—those with $100-$700 billion in assets—to issue and maintain long-term unsecured debt, or LTD, equal to 3.5% of total assets or, if greater, 6% of "risk weighted" assets.

Construction loans have a "risk weight" of 150%, so that the 6% capital requirement becomes 9%. US Treasuries and agency-backed mortgages have a zero-risk weight so that the 6% becomes zero.

The LTD amount is roughly the same as the holding company's required equity capital. The holding company must lend the LTD amount in cash to its bank on a deeply subordinated basis. Thus, the rule would effectively double the minimum capital a large holding company is required to invest in its bank.

The required LTD amount would be phased in over three years, starting the year after the rule is adopted. Already-outstanding "legacy" debt counts against the required LTD amount so long as it meets the requirements for LTD: unsecured, no guaranties, no covenants, no defaults other than non-payment or bankruptcy, no equity conversion, and at least two years left to maturity (50% of one-to-two year debt would qualify as LTD). The proposed LTD rule would affect different holding companies very differently.

A large holding company with both legacy LTD and large bank deposits can simply use the deposits to buy subordinated LTD from its bank. And that's fine. The deposits would be priority claims in any bank receivership, diluting the recovery of uninsured depositors, whereas the bank's LTD would be subordinated to all other creditors.

Capital One is a fine example: As of Sept. 30, 2023, it reported long-term unsecured debt exceeding $31 billion, deposits at its bank exceeding $27 billion, and an LTD amount of $21 billion. With a little effort including the elimination of $3 billion in subordinated debt, Capital One can probably use its existing debt to comply with the proposed rule.

A holding company with small deposits at its bank and substantial non-bank assets would sell or borrow against those non-bank assets to fund subordinated loans to its bank. Charles Schwab Corp., for example, reports only $1 billion in cash, but it could borrow $16 billion—its required LTD amount—against its $33 billion (book value) investment in its broker/dealer.

A holding company with cash to fund subordinated loans to its bank, but insufficient legacy LTD, could meet the requirements of the rule by issuing zero coupon notes to the public or even dividending zero coupon notes to its shareholders. The LTD rule doesn't specify either discount or coupon for a holding company's LTD.

And then there are holding companies with very few assets. Northern Trust reports less than $600 million in cash and almost no non-bank assets. The proposed rule would require Northern Trust to raise more than $5 billion in high-interest LTD (Truist Financial Corp. just issued LTD at 7.7%) to lend to its bank in replacement of deposits paying average interest of 3.35%—reducing net income by about $200 million per year, or one-third of its dividend.

Northern Trust illustrates the incoherence of the source of strength doctrine and the correct approach to future regulation.

A source of strength rule, properly written, should require each holding company to execute a capital adequacy and liquidity maintenance agreement with the Fed, the FDIC, and the regulator of the holding company's bank with the following terms:

  • The holding company would agree to buy bank equity in an amount specified by the Fed or bank regulator prior to a bank receivership or by the FDIC during receivership.
  • The amount specified by the Fed or bank regulator in any year wouldn't exceed the LTD amount in that year, less subordinated loans to the bank under the LTD rule—the net LTD amount.
  • The amount specified by the FDIC in receivership would not exceed the net LTD amount plus bank dividends during the four years prior to the receivership.
  • The holding company would agree to hold all of its deposits at its bank and would agree to subordinate its deposit claims to the prior payment of all other liabilities of the bank.
  • The agreement would satisfy the Bankruptcy Code's requirements for immediate enforcement in bankruptcy.
  • The holding company's compliance with the LTD rule would be suspended if it had executed and complied with the capital and liquidity maintenance agreement.

The above-proposed source of strength rule should apply to all holding companies—there's no reason to have Charles Schwab commit the equity of its broker/dealer to the support of its bank, but not Raymond James or Hilltop Holdings.

Such a source of strength rule would accomplish the professed goal of the LTD rule instead of futilely requiring shell companies to borrow at high interest rates against assets they don't have, and inadequately requiring small but still asset-rich holding companies to contribute assets they do have.

Originally published by Bloomberg Law.

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